MBA608 2_Review of _Corporate Finance-converted

generally speculating on market direction – not hedging. Trading Transactions: A Bid is what someone is willing to pay for an asset. The Ask, or offer, is what someone is willing to accept to sell an asset. As a Forex trader, you can Buy at the Ask and Sell at the Bid. A price quote of EURUSD at 1.3085 means that one euro is equal to 1.3085 US $ dollars. When that number increases, it means the Euro is appreciating while the US $ dollar is depreciating and vice versa. USDJPY is trading at 124.00. It means 1 US $ dollar is equal to 124 Japanese yen. An increase in the number means that the US $ dollar is appreciating while the Japanese yen is depreciating, and vice versa. Again, if a currency quote goes higher, that increases the value of the base currency. A lower quote means the base currency is weakening. Cross currency pairs do not involve US $ dollar. EURJPY at a price of 126.34, means that 1 euro is equal to 126.34 Japanese yen. There are transactional costs incurred each time a bank makes a trade. There are two exchange rates for each currency pair: The Bid, which is the rate at which the bank can Sell; and the Ask, is the rate at which it can Buy. The difference is known as the spread, and determines the transactional cost of the trade. Each currency pair has its own fixed Bid-Ask spread. Based on a 100,000-unit contract trade of EURUSD, the total transactional cost of 3 pips would be $30.00. Spread = Ask – Bid (1.2960 – 1.2957 = .0003) Cost = .0003 * 100,000 = $30.00 (A pip is the minimum movement for a currency pair.) Types of Prudential Risks: While banks are exposed to a number of different types of risk in the conduct of their foreign exchange business, most of these risks also feature in domestic banking business. The accounting department should receive without delay all the information from the dealers that is necessary to ensure that no deal goes unrecorded. All foreign exchange contracts whether spot or forward, should be promptly confirmed in writing. Dealers should never write their own outgoing confirmations; this should be the 250 CU IDOL SELF LEARNING MATERIAL (SLM)

responsibility of the accounting department alone, which should also be the first to receive the corresponding incoming confirmations. If confirmations are not forthcoming, the counterparties should be contacted promptly. In addition, foreign exchange accounting should be organized in such a way that the bank’s management is continuously in possession of a full and up-to-date picture of the bank’s position in individual currencies and with individual counterparties. This information should not only include the head office but also the positions of affiliates at home or abroad. Moreover, periodic and frequent revaluations at current market rates should permit the monitoring of the development of the bank’s profits or losses on its outstanding foreign exchange book. It will be the responsibility of the internal audit function to make sure that all dealers observe their instructions and the code of behavior required from them, and that accounting procedures meet the necessary standards of accuracy, promptness and completeness. For this purpose, it will be advisable that not only the internal audits and inspections should take place at regular intervals, but that occasional spot checks are to be made. As a further safeguard against malpractices, the auditors, in co-operation with the management may seek an exchange of information on outstanding foreign exchange contracts with the counterparties to these contracts. In order to facilitate internal supervision and monitoring of open exchange of position, branches should daily report their dealing positions to head office. While the extent to which individual branches are permitted to run open positions is a matter for a bank’s management, the decision may be on the basis of geographical factors and the dealing expertise of the branch concerned, etc. However, the head office should strictly enforce the limits it sets in order to keep control of its worldwide exposure. Closing out a Position: An open position is one that is live and on-going. As long as the position is open, its value will fluctuate in accordance with the exchange rate in the market. Any profits or losses will exist on paper only and will be reflected in the margin account. To close out open position, what is needed is to conduct an equal and opposite trade in the same currency pair. For example, if a bank has bought (“gone long”) one lot of EURUSD (at the prevailing offer price), it can close out that position by subsequently selling one EURUSD lot (at the prevailing bid price). Some examples are given below. 251 CU IDOL SELF LEARNING MATERIAL (SLM)

Stop-loss Limit: The Concept: The Forex (Foreign Exchange) Market behaves differently from other markets. The Forex market’s speed, volatility, and enormous size are unlike anything else in the financial world. Forex market is uncontrollable. No single event, individual, or factor impacts on it. It is a perfect market. Just like any other speculative business, increased risk entails chances for a higher profit/loss. Any transaction involving currencies involves risks including, but not limited to, the potential for changing political and/or economic conditions that may substantially affect the price or liquidity of a currency. The market is highly speculative and volatile in nature. Any currency can become very expensive or very cheap in relation to any or all other currencies in a matter of days, hours or sometimes, in minutes. This unpredictable nature of the currencies is what attracts an investor to trade and invest in the currency market. Following are the foreign exchange risk management issues that may come up in day-to-day foreign exchange transactions: 1. Unexpected corrections in currency exchange rates, 2. Wild variations in foreign exchange rates, 3. Volatile markets offering profit opportunities, 4. Lost payments, 5. Delayed confirmation of payments and receivables, and 6. Divergence between bank drafts received and the contract price. Stop-loss limit allows traders to set an exit point for a losing trade. A stop-loss limit indicates an amount of money that a portfolio’s single-period market loss should not exceed. Various periods may be used, and sometimes multiple stop-loss limits are specified for different periods. A trader might be given the following stop-loss limits: A limit violation occurs whenever a portfolio’s single-period market loss exceeds a stop-loss limit. In such an event, a trader is usually required to unwind or otherwise hedge material exposures—hence the name stop-loss limit. Stop-loss as a risk management tool is useful in equity market as well. No one can pick winning stocks 100% of the time. Let’s say a bank buys a stock at Rs.200 with the view that it will go up to Rs.240. Now it has to decide what to do if the stock does not go up, but suddenly starts to fall. 252 CU IDOL SELF LEARNING MATERIAL (SLM)

A decision is made that if the stock moves below Rs. 190, the bank will accept that it was wrong about the direction of the stock, sell the position immediately, and take a small loss. By taking small losses, it preserves trading capital, which allows the bank to trade again on the next day. Before the bank even gets into a position, it has to measure the risk-reward ratio. In the above example, if the bank were to correct the stock pick, it would have made 20 points. If it were wrong in the stock pick, it would take a loss of 10 points. That is a risk-reward of 4:1. Assuming that the bank was correct only about stock picks 50% of the time and it makes four trades. Two were winners (2×4 points) equaling 8 points. Two trades were losers (2 x 1) totaling 2 points. There is a gain of 6 points by only selecting winning stocks 50% of the time. Assuming the bank was the worst stock picker in the world and was only correct 25% of the time, it would still have a gain of 1 point. It is important to keep risk-reward ratio 4:1. If the bank can only find a risk-reward ratio of 2:1, it is better to leave it alone. If the market is behaving in a way that the bank only finds risk-reward ratios of 2:1, it has probably no idea as to which way the market is going to move. The market spends most of its time moving sideways. The bank must have the discipline to stay on the side-lines when it does not feel comfortable. Getting into low risk- reward positions because the bank wants to be in the game is wrong. It shows a lack of discipline and the punishment is losing capital. Discipline includes hitting the stops and not following the temptation to stay with a losing position that has gone through the stop-loss level. Setting Stop-Loss limits: Setting of a stop-loss limit entails many considerations. First and foremost is the purpose of the stop-loss limit. For example, if the bank depends entirely on stop-loss limits for limiting market risk, those limits are likely to play a different role than if merely using them to supplement value-at-risk limits or exposure limits. In the latter case, the stop-loss limits represent somewhat of a belt-and- suspenders approach to limits. The bank may make the stop-loss limits fairly high so that value-at-risk or exposure limits would typically apply before the stop-loss limits did. In such case, the stop-loss limits would merely be a safeguard against some sort of situation that the value-at-risk or exposure limits clearly were failing to adequately address. Another dimension is the sanction that a violation triggers. The bank may have “green” limits that simply require that management be informed that there is a loss situation. Higher “yellow” limits might require that the trader report on how and why the situation arose and indicate a constructive plan for dealing with the situation moving forward. 253 CU IDOL SELF LEARNING MATERIAL (SLM)

Even higher “red” limits might require the immediate hedging of the position. In practice, the bank sets the limits based upon an assessment of what is a reasonable loss given the horizon and the trader’s mandate In this respect, the liquidation period is not particularly relevant. The process may not be entirely scientific. It will entail subjective opinion. At the end of the day, a large part of the question is how management wants the system to work … and how often do they want to have to deal with stop-loss limit violations? Do they want to deal with them infrequently … but take strong steps when violations do occur, or do they want to have frequent violations that require a more modest response? Limitations: Stop-loss limits have shortcomings. Single-period market loss is a retrospective risk metric. It only indicates risk after the financial consequences of that risk have been realized. Also, it provides an inconsistent indication of risk. If a portfolio suffers a large loss over a given period, this is a clear indication of risk. If the portfolio does not suffer a large loss, this does not indicate an absence of risk. Another problem is that traders cannot control the specific losses they incur, so it is difficult to hold traders accountable for isolated stop-loss limit violations. However, the existence of stop- loss limits does motivate traders to manage portfolios in such a manner as to avoid limit violations. Despite their shortcomings, stop-loss limits are simple and convenient to use. Non-specialists easily understand stop-loss limits. A single risk metric can be applied consistently across an entire hierarchy of limits. As the portfolio loss encompasses all sources of market risk, just one or a handful of limits are required for each portfolio or sub-portfolio. For these reasons, stop-loss limits are widely implemented by trading organizations. Concept # 3. Duration: Duration is a measure of the average (cash-weighted) term-to- maturity of a bond. Duration is measured in years. There are two types of durations, Macaulay duration and modified duration. It is named after its creator, Frederick Macaulay. Macaulay duration is useful in immunization, where a portfolio of bonds is constructed to fund a known liability. Immunization is a strategy that matches the duration of assets and liabilities, thereby minimizing the impact of interest rates on the net worth. Duration is a weighted average of the times that interest payments and the final return of principal are received. The weights are the amounts of the payments discounted by the yield-to-maturity of the bond. 254 CU IDOL SELF LEARNING MATERIAL (SLM)

For all bonds, duration is shorter than maturity except zero coupon bonds, whose duration is equal to maturity. The weight of each cash flow is determined by dividing the present value of the cash flow by the price It is an important measure for investors to consider, as bonds with higher durations are more risky and have higher price volatility than bonds with lower durations. It is important to note, however, that duration changes as the coupons are paid to the bondholder. As the bondholder receives a coupon payment, the amount of the cash flow is no longer on the timeline, which means it is no longer counted as a future cash flow that goes towards repaying the bondholder. Duration increases immediately on the day a coupon is paid, but throughout the life of the bond, the duration is continually decreasing as time to the bond’s maturity decreases. Duration will decrease as time moves closer to maturity, but duration will increase momentarily on the day a coupon is paid and removed from the series of future cash flows— all this occurs until duration, as it does for a zero-coupon bond, eventually converges with the bond’s maturity. Besides the movement of time and the payment of coupons, there are other factors that affect a bond’s duration: the coupon rate and its yield. Bonds with high coupon rates and in turn high yields will tend to have lower durations than bonds that pay low coupon rates, or offer a low yield. When a bond pays a higher coupon rate, or has a high yield, the holder of the security receives repayment for the security at a faster rate. The computation of duration is done as under: 255 CU IDOL SELF LEARNING MATERIAL (SLM)

Concept # 4. Modified Duration: Modified duration is an extension of Macaulay duration and is a useful measure of the sensitivity of a bond’s prices (the present value of the cash flows) to interest rate movements. Modified duration is a measure of the price sensitivity of a bond to interest rate movements. It accounts for changing interest rates. Because the interest rates affect yield, fluctuating interest rates will affect duration. Modified formula shows how much the duration changes for each percentage change in yield. For bonds without any embedded features, bond price and interest rate move in opposite directions. There is an inverse relationship between modified duration and an approximate one-percentage change in yield. As the modified duration shows how a bond’s duration changes in relation to interest rate movements, the formula is appropriate for investors wishing to measure the volatility of a particular bond. Modified duration follows the concept that interest rates and bond prices move in opposite directions. This formula is used to determine the effect a 100 basis point (1%) change in interest rates will have on the price of a bond Modified duration t is calculated as shown below: Where y = yield to maturity and 256 n = number of discounting periods in year (2 for semi – annually paid bonds) CU IDOL SELF LEARNING MATERIAL (SLM)

The Dmod (modified duration) from the earlier example would be worked out as under: Dmod = 1 * 4.26/ (1 + .075/2) = 4.106 years Modified duration indicates the percentage change in the price of a bond for a given change in yield. The percentage change applies to the price of the bond including accrued interest. In the section showing a bond’s price as the present value of its cash flows, the bond shown was priced initially at par (100), when the YTM was 7.5%, with Macaulay duration of 4.26 years. Assume that the bond was re-priced for an increase and decrease in rates of 2.5% (i.e. =+/- 2.50%) A change in the yield of +/- 2.5% should result in a % change in the price of the bond. The computation of the same is as under: % Price Change = -1 * Modified Duration * Yield Change = -/+1 * (4.106)*0.025 = -/+4.106 * .025 = +/-0.10265 = (+/- 10.265 %). Since the bond was initially priced at par, the estimated prices are $110.27 at 5.00% and $89.74 at 10.00%. In reality, there may be certain variation in the estimated change in the bond price due to the convexity of the bond, which must be included in the price change calculation when the yield change is large. However, modified duration is still a good indication of the potential price volatility of a bond. Concept # 5. Convexity: The previous percentage price change calculation was not fully accurate because it did not recognize the convexity of the bond. Convexity is a measure of the amount of “whip” in the bond’s price yield curve and is so named because of the convex shape of the curve. Because of the shape of the price yield curve, for a given change in yield down or up, the gain in price for a drop in yield will be greater than the fall in price due to an equal rise in yields. This slight “upside capture, downside protection” is what convexity accounts for. Mathematically Dmod is the first derivative of price with respect to yield and convexity is the second (or convexity is the first derivative of modified duration) derivative of price with respect to yield. An easier way to think of it is that convexity is the rate of change of duration with yield, and accounts for the fact that as the yield decreases, the slope of the price— yield curve and duration, will increase. Similarly, as the yield increases, the slope of the curve will decrease, 257 CU IDOL SELF LEARNING MATERIAL (SLM)

as will the duration. By using convexity in the yield change calculation, a much closer approximation is achieved. Using Convexity (C) and Dmod, % Price Chg. =. Using the previous example, convexity can be calculated and it results in the expected price change being: Concept # 6. RAROC (Risk Adjusted Return on Capital): A basic premise of finance is that capital should only be invested if the probable future return on that capital will exceed its cost. The potential investment that requires the apportionment of existing capital or the generation of incremental capital, should meet such a test. Risk-adjusted return on capital (RAROC) is a relatively new tool for applying this test in the lending and credit risk management context. It is known as return on risk-adjusted capital (RORAC) or risk-adjusted return on risk-adjusted capital (RARORAC) In financial analysis, riskier projects and investments must be evaluated differently from their risk less counterparts. By discounting risky cash flows against less risky cash flows RAROC accounts for changes in the profile of the investment Thus, when companies need to compare and contrast two different projects or investments, it is important to take into account these possibilities. During the 1980s, Bankers Trust developed a firm wide RAPM that they called risk-adjusted return on capital (RAROC). Bankers Trust was a commercial bank that had adopted a 258 CU IDOL SELF LEARNING MATERIAL (SLM)

business model much like that of an investment bank. It had divested its retail deposit and lending businesses. It actively dealt in exempt securities and had an emerging derivatives business. Such wholesale activities are easier to model than the retail businesses Bankers Trust had divested, and this certainly facilitated the development of the system. RAROC was well publicized, and during the 1990s, a number of other banks developed their own firm wide systems. Today, many banks have built such models, and some use them as decision-making tools at the heart of their lending processes. RAROC systems allocate capital for two basic reasons: (1) risk management, and (2) Performance evaluation. For risk-management purposes, the overriding goal of allocating capital to individual business units is to determine the bank’s optimal capital structure. This process involves estimating how much the risk (volatility) of each business unit contributes to the total risk of the bank and, hence, to the bank’s overall capital requirements. For performance-evaluation purposes, RAROC systems assign capital to business units as part of a process for determining the risk- adjusted rate of return and, ultimately, the economic value added to each business unit. The objective in this case is to measure a business unit’s contribution to shareholder value and, thus, to provide a basis for effective capital budgeting and incentive compensation at the business-unit level. Risk is looked upon as any phenomenon that creates potential volatility in the economic cash flows of the bank. The purpose of risk capital is to provide comprehensive coverage of losses for the organization as a whole. By “comprehensive,” they mean coverage of all sources of risk with a very high degree of confidence. Computation of RAROC: RAROC measures performance on a risk-adjusted basis. It is calculated as the economic return divided by economic capital. RAROC helps determine if a company has the right balance between capital, returns and risk. The central concept in RAROC is economic capital: the amount of capital a company should put aside need be based on the risk it runs. The calculation of RAROC is relatively simple once all the risk calculations have been completed. RAROC is computed by dividing risk-adjusted net income by the total amount of economic capital assigned based on the risk calculation. Risk adjusted net income is determined by taking the financial data allocation to the businesses and adjusting the income statement for expected loss. 259 CU IDOL SELF LEARNING MATERIAL (SLM)

RAROC = Revenues – Cost – Expected Loss/Economic Capital Economic Profit = Revenues – Cost – Expected Loss – RoEC X Economic Capital RAROC = Risk Adjusted Return on Capital RoEC = required return on Economic Capital RAROC and EP are equivalent measures, as RAROC > RoEC if and only if EP > 0 Where expected loss is the mean of the loss distribution associated with some activity, most typically it represents expected loss from defaulting loans or from operational risk. The original Bankers Trust RAROC system provided results on an after-tax basis. Today, systems typically perform calculations before tax. Advantages of RAROC: The primary advantage that can be provided by a RAROC model lies in the discipline it can bring to lending decisions. The model itself is not the objective because it will only be as good as its builders. RAROC is not an end in itself. Its advantages are more in the way that it ensures that risk and reward remain linked and in the consistency of decision thinking that it forces. Having a calculated RAROC for a transaction does not obviate the need for a careful review of all new credits and a senior screening (whether by committee or some other means) of deals that bring a lot of incremental risk. However, a RAROC model provides a number of advantages to a discriminating user, including the following: 1. It provides a platform to calculate both risk and return and thereby remove the bias from one objective or the other. A RAROC calculation can bring an added dimension by showing the use and return on capital. 2. If provided to all commercial/corporate lenders and used appropriately, a RAROC model can almost ensure that decisions made in different locations, at different times, withdifferent relationship managers will be made using the same principles and calculation methodology. Banks have many decision-makers in the lending business, and their negotiation skills can vary substantially. A RAROC model tends to level the playing field and give all staff the chance for a common comparison of their transactions. 3. A RAROC model emphasizes that risk must be compensated for, while ensuring that the risk is both measured and appropriately considered through the enforced completion of the calculation. 4. A RAROC model can provide a “what if” capability to the user. In most cases, the 260 CU IDOL SELF LEARNING MATERIAL (SLM)

relationship manager or the credit officer can solve for the price or the risk and rebalance by adjusting one or the other. Although these benefits can provide some improvement to the traditional credit process, it must be repeated that the RAROC calculation is not an end in itself. One of the realities of RAROC is that the calculation is certain to change because risk changes as time passes. As such, it is not a solution in itself, nor is it more than a measure at a point in time (albeit a critical point in time). The critical question is whether its introduction will improve the existing lending process, the decision-making ability, and the performance of corporate lending. The answer is specific to each institution. RAROC is not an off-the-shelf technology one can apply, but a complicated set of rules that needs to be calibrated for each bank’s unique set of products, incentive compensation plans, pricing models, and, most importantly, information systems. Those who build the RAROC models, however, tend to learn a great deal about their management of loan assets. They tend to improve on their rating system, they put more consistency into structuring and pricing, and they are often forced to upgrade their management information systems. This is why the production of a RAROC model can be a rewarding journey. Concept # 7. Auditing Risk Management: Risk management is one of the means to attain a better trade-off between risk and return. It is not a panacea for an assured and sustained success. Risk management, as a function in a bank is fraught with risks. Unless appropriate measures are taken in implementing the process, the managing of risk itself can give rise to problems. The risks involved in risk management (RM) are: 1. Inadequate resources for RM, 2. Exclusion of RM cost from business cost and business case for project, 3. Unaffordable risk treatment, 4. Wrong mix of RM team, 5. Risk team not being integrated with other business groups, 6. Late discovery of risk, 7. Risk of abandoning formal process of risk management, 8. Optimization bias, 261 CU IDOL SELF LEARNING MATERIAL (SLM)

9. Planned treatment becoming ineffective, and 10. Inappropriate risk management methods. To address these issues, it is necessary that like any other banking function, risk management is also subjected to internal/external audit. The audit may be different from the usual audit of credit or resources functions. The basic approach may involve: Figure 9.2 The Process: The audit process has to focus on checking the capability profile of concerned people, leadership, policies/procedures, partners/ resources, and processes as also outcome of the risk management followed. The purpose is to assess the capability from the perspective of risk management within the bank. The intention is not a personnel appraisal of people involved as it would come out as a by- product of the examination process. The focus is on examining the preparedness of all concerned to manage the bank’s risk areas. The capability is judged by many factors. Awareness and understanding about the risk issues is the first factor to be considered. In case the people are not conscious of the risks undertaken and the business that involves risk, the situation is considered critical. As the risk management functionaries would put in place the plan of action, the level of implementation and progress made in putting the plan to performance is another factor that is examined. There may be certain basic measures like segregation of duties, deal confirmations, follow-up of pending response, etc. Further, there would be critical areas like adherence to risk limits, 262 CU IDOL SELF LEARNING MATERIAL (SLM)

generation and reporting of exceptions, following up of laid down approval procedures, and the like. Audit has to look into all these aspects. While the risk management policy would state about the alternate sources of funds through unconfirmed lines of credit, the operators may not be in know of such arrangements. Checking on such issues is important. The best way to assess the adequacy of risk management mechanism is not based on the amount of income generated. As the future is not likely to behave like the past always, the possible risk situations in the future may be different. Actual audit is the only alternative to keep the appetite for risk management alive. The auditor can take an overall view and come with rating such as unsatisfactory, satisfactory, good, very good or excellent. An illustrative check list of the following kind could be a useful starting point for conduct of an audit of risk management function: 263 CU IDOL SELF LEARNING MATERIAL (SLM)

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CORPORATE RISK MANAGEMENT Corporate risk management refers to all of the methods that a company uses to minimize financial losses. Risk managers, executives, line managers and middle managers, as well as all employees, perform practices to prevent loss exposure through internal controls of people and technologies. Risk management also relates to external threats to a corporation, such as the fluctuations in the financial market that affect its financial assets. Protecting Shareholders A corporation has at least one shareholder. A large corporation, such as a publicly-traded or employee-owned firm, has thousands, or even millions, of shareholders. Corporate risk management protects the investment of shareholders through specific measures to control risk. For example, a company needs to ensure that its funds for capital projects, such as construction or technology development, are protected until they are ready to use. Economic Value Techniques of the first form focus on a concept called economic value. If a market value exists for an asset, then that market value is the asset’s economic value. If a market value doesn’t exist, then economic value is the “intrinsic value” of the asset—what the market value of the asset would be, if it had a market value. Economic values can be assigned in two ways. One is to start with accounting metrics of value and make suitable adjustments, so they are more reflective of some intrinsic value. This is the approach employed with economic value added (EVA) analyses. The other approach is to construct some model to predict what value the asset might command, if a liquid market existed for it. In this respect, an unflattering name for economic value is mark-to-model value. Once some means has been established for assigning economic values, these are treated like market values. Standard techniques of financial risk management—such as value-at-risk (VaR) or economic capital allocation—are then applied. This economic approach to managing business risk is applicable if most of a firm’s balance sheet can be marked to market. Economic values then only need to be assigned to a few items in order for techniques of financial risk management to be applied firm wide. An example would be a commodity wholesaler. Most of its balance sheet comprises physical and forward positions in commodities, which can be mostly marked to market. More controversial has been the use of economic valuations in power and natural gas 265 CU IDOL SELF LEARNING MATERIAL (SLM)

markets. The actual energies trade and, for the most part, can be marked to market. However, producers also hold significant investments in plants and equipment—and these cannot be marked to market. Suppose some energy trades spot and forward out three years. An asset that produces the energy has an expected life of 50 years, which means that an economic value for the asset must reflect a hypothetical 50-year forward curve. The forward curve doesn’t exist, so a model must construct one. Consequently, assigned economic values are highly dependent on assumptions. Often, they are arbitrary. In this context, it isn’t enough to assign economic values. Value-at-risk analyses require standard deviations and correlations as well. Assigning these to 50-year forward prices that are themselves hypothetical is essentially meaningless—yet, those standard deviations and correlations determine the reported value-at-risk. Such practices got out of hand in the US energy markets during the late 1990s and early 2000s. The most publicized case was Enron Corp., which went beyond using economic values for internal reporting and incorporated them into its financial reporting to investors. The 2001 bankruptcy of Enron and subsequent revelations of fraud tainted mark-to-model techniques. Book Value The second approach to addressing business risk starts by defining risks that are meaningful in the context of book value accounting. Most typical of these are: • earnings risk, which is risk due to uncertainty in future reported earnings, and • cash flow risk, which is risk due to uncertainty in future reported cash flows. Of the two, earnings risk is more akin to market risk. Yet, it avoids the sometimes arbitrary assumptions of economic valuations. A firm’s accounting earnings are a well-defined notion. A problem with looking at earnings risk is that earnings are, well, non-economic. Earnings may be suggestive of economic value, but they can be misleading and are often easy to manipulate. A firm can report high earnings while its long term franchise is eroded by lack of investment or the emergence of competing technologies. Financial transactions can boost short-term earnings at the expense of long-term earnings. Cash flow risk is less akin to market risk. It relates more to liquidity than the value of a firm, but this is only partly true. As anyone who has ever worked with distressed firms can attest, “cash is king.” When a firm gets into difficulty, earnings and market values don’t pay the bills. Cash flow is the life blood of a firm. However, as with earnings risk, cash flow risk 266 CU IDOL SELF LEARNING MATERIAL (SLM)

offers only an imperfect picture of a firm’s business risk. Cash flows can also be manipulated, and steady cash flows may hide corporate decline. Techniques for managing earnings risk and cash flow risk draw heavily on techniques of asset-liability management—especially scenario analysis and simulation analysis. They also adapt techniques of financial risk management. In this context, value-at-risk (VaR) becomes earnings-at-risk (EaR) or cash-flow-at-risk (CFaR). For example, EaR might be reported as the 10% quantile of this quarter’s earnings. The actual calculations of EaR or CFaR differ from those for VaR. These are long-term risk metrics, with horizons of three months or a year. VaR is routinely calculated over a one-day horizon. Also, EaR and CFaR are driven by rules of accounting while VaR is driven by financial engineering principles. Typically, EaR or CFaR are calculated by first performing a simulation analysis. That generates a probability distribution for the period’s earnings or cash flow, which is then used to value the desired metric of EaR or CFaR. One decision that needs to be made with EaR or CFaR is whether to use a constant or contracting horizon. If management wants an EaR analysis for quarterly earnings, should the analysis actually assess risk to the current quarter’s earnings? If that is the case, the horizon will start at three months on the first day of the quarter and gradually shrink to zero by the end of the quarter. The alternative is to use a constant three-month horizon. After the first day of the quarter, results will no longer apply to that quarter’s actual earnings, but to some hypothetical earnings over a shifting three-month horizon. Both approaches are used. The advantage of a contracting horizon is that it addresses an actual concern of management— will we hit our earnings target this quarter? A disadvantage is that the risk metric keeps changing—if reported EaR declines over a week, does this mean that actual risk has declined, or does it simply reflect a shortened horizon? STRATEGIC RISK MANAGEMENT Risk has traditionally been seen as something to be avoided – with the belief that if behavior is risky, it’s not something a business should pursue. But the very nature of business is to take risks to attain growth. Risk can be a creator of value and can play a unique role in driving business performance, and so strategies for corporate risk management must be developed to help guide the business as it decides which risks to take. Risk management, then, is the identification, assessment and prioritization of risks or uncertainties in business. Any strategies for corporate risk management must be backed up by 267 CU IDOL SELF LEARNING MATERIAL (SLM)

a risk management analysis and a plan for controlling or mitigating those risks. But what are risks in corporate life? While the obvious come immediately to mind – the financial risk of running out of money or inheriting bad debt, or the risk of being unable to continue operations, for example due to workers going on strike or a force of nature closing a plant – it’s important to remember corporate risk doesn’t just encompass operational and financial risks, but also risks to the wider corporate strategy. In fact, studies indicate that financial risks only generate about 10% of major declines in market capitalization, while operational risks account for around 30%; the other 60% of declines are a result of strategic risks, and yet the strategy comes in a poor third in risk- prioritization exercises. Strategic corporate risks could include: Shifts in consumer demand and preferences Legal and regulatory changes Competitive pressures Merger integrations Technological changes Senior management turnover Stakeholder pressure You’ll note that a lot of strategic risk closely aligns with the compliance and governance function of an entity, and so these teams must be involved and informed as strategies for corporate risk management are devised. Building strategies for corporate risk management Strategies for corporate risk management usually consist of two processes: setting the framework for the company’s risk management and setting the communication channels in the organization. Risk management is, though, useless unless you measure and know your risks first. You must also have a robust procedure for ongoing monitoring and a cycle of continual assessment. Risk management planning encompasses three elements: Operational risk management, such as damage to property or other risks that can’t be planned for. 268 CU IDOL SELF LEARNING MATERIAL (SLM)

Financial risk management, which emerges from the effects of markets on an entity’s assets; this includes risks to credit, price and liquidity. Strategic risk management, or thinking about the bigger picture and the future of the company. Consider what happened to Kodak once digital cameras came along, and ask if that was a failure of operational risk management or strategic risk management. One of the best available metrics of risk measurement is economic capital, which is the amount of equity required to cover any unexpected losses. The economic capital required to support an individual risk can be calculated and results aggregated across all risks. Dividing the anticipated after-tax return on each strategic initiative by the economic capital gives you a RAROC, or risk adjusted return on capital, figure – if the RAROC is less than the cost of capital, it will destroy value and is, therefore, a huge risk to the company. Outside of economics, there are five steps to take when first assessing the risk and deciding on the best solutions for mitigation: Identify the risk: Risks can be internal or external, so include any events that could cause problems or benefits for the company. Analyze the risk: Thoroughly analyze the potential effects each risk will have on consumer behavior, the company or any endeavors underway. Evaluate the risk: Rank risks according to the likelihood of each outcome to see how severely a set risk could impact the company or its strategy. Treat the risk: Look at ways to reduce the probability of a negative risk and increase the probability of positive risks, preparing preventative and contingency plans as needed. Monitor the risk: Track variables and proposed possible threats, and calmly treat any problems that arise as your tracking system identifies changes. Once the risk assessment is complete, assign a strategy to treat the identified risks. Generally, there are four ways to handle a risk: Avoid the risk, or forfeit all activity that carries the risk – though this also means forfeiting all associated potential returns and opportunities. Reduce the risk, or make small changes to reduce the weight of both risk and reward. Transfer or share the risk, or redistribute the burden of loss or gain by entering partnerships or bringing on new entities. Accept the risk, or assume any loss or gain entirely; this is usually put into play for small 269 CU IDOL SELF LEARNING MATERIAL (SLM)

risks where any loss can be easily absorbed by the entity. The role of the Board in strategies for corporate risk management One of the central tenets of any Board is to oversee risk, but that job has become highly complex as market forces become more volatile and modern corporates grow into multinational behemoths. A strong enterprise risk management (ERM) process doubles as both an internal safeguard and a shareholder engagement tool. We’ve previously reported that an ERM framework is a great starting point for board discussion, but also acts as proof that the company is systematically analyzing and rigorously managing risk in case of investor and shareholder nerves – all things the Board cares about and is responsible for. The COSO framework says the role of the board in risk oversight includes: reviewing, challenging and concurring with management on the proposed strategy and risk appetite; aligning strategy and business objectives with mission, vision and values; participating in significant business decisions; formulating responses to significant performance or portfolio fluctuations; and formulating responses to any deviation from core values; plus approving management incentives and remuneration, and participating in investor and stakeholder relations. Remember, there must be a robust, unshakeable relationship between risk management and corporate governance in any entity. Falling out of compliance with local regulations is a big risk that must be managed effectively, and strategies for corporate risk management must include a focus on compliance. How technology can help manage corporate risk All of this leads up to one resounding conclusion: To keep on top of risks, and to manage them effectively, it pays to incorporate technology into your risk management practices. The right software platforms can automate regular tasks, act as central repositories for key information, and make roles, responsibilities and deadlines clear through process management. It’s important to assess all three risk areas – financial, operational and strategic – to safeguard your company’s future growth and reputation, but it’s just as important to regularly check in with your risk assessments and to ensure progress toward mitigation is going according to plan. This is where technology can help streamline tasks, and where Diligent’s entity and board management software can help ease the burden on company secretaries, general counsels and legal operations teams. Acting as that all-important central repository for all entity management information, Diligent software provides secure file sharing and communications, virtual data rooms, assessment tools and board management tools. Compliance workflows and calendars help keep risk 270 CU IDOL SELF LEARNING MATERIAL (SLM)

management on track through notifications and RAG status, while entity relationship diagramming can reveal compliance risks that may not be obvious at first sight. All of this can help drive risk assessments and enhance risk management strategies. PROJECT RISK MANAGEMENT Risk management activities are applied to project management. Project risk is defined by PMI as, \"an uncertain event or condition that, if it occurs, has a positive or negative effect on a project’s objectives.\" Project risk management remains a relatively undeveloped discipline, distinct from the risk management used by Operational, Financial and Underwriters' risk management. This gulf is due to several factors: Risk Aversion, especially public understanding and risk in social activities, confusion in the application of risk management to projects, and the additional sophistication of probability mechanics above those of accounting, finance and engineering. With the above disciplines of Operational, Financial and Underwriting risk management, the concepts of risk, risk management and individual risks are nearly interchangeable; being either personnel or monetary impacts respectively. Impacts in project risk management are more diverse, overlapping monetary, schedule, capability, quality and engineering disciplines. For this reason, in project risk management, it is necessary to specify the differences (paraphrased from the \"Department of Defense Risk, Issue, and Opportunity Management Guide for Defense Acquisition Programs\"): Risk Management: Organizational policy for optimizing investments and (individual) risks to minimize the possibility of failure. Risk: The likelihood that a project will fail to meet its objectives. A risk: A single action, event or hardware component that contributes to an effort's \"Risk.\" An improvement on the PMBOK definition of risk management is to add a future date to the definition of a risk. Mathematically, this is expressed as a probability multiplied by an impact, with the inclusion of a future impact date and critical dates. This addition of future dates allows predictive approaches. Good Project Risk Management depends on supporting organizational factors, having clear roles and responsibilities, and technical analysis. Chronologically, Project Risk Management may begin in recognizing a threat, or by examining an opportunity. For example, these may be competitor developments or novel products. Due to lack of definition, this is frequently performed qualitatively, or semi- 271 CU IDOL SELF LEARNING MATERIAL (SLM)

quantitatively, using product or averaging models. This approach is used to prioritize possible solutions, where necessary. In some instances it is possible to begin an analysis of alternatives, generating cost and development estimates for potential solutions. Once an approach is selected, more familiar risk management tools and a general project risk management process may be used for the new projects: 1. A Planning risk management 2. Risk identification and monetary identification 3. Performing qualitative risk analysis 4. Communicating the risk to stakeholders and the funders of the project 5. Refining or iterating the risk based on research and new information 6. Monitoring and controlling risks Finally, risks must be integrated to provide a complete picture, so projects should be integrated into enterprise wide risk management, to seize opportunities related to the achievement of their objectives. Project risk management tools In order to make project management effective, the manager’s use risk management tools. It is necessary to assume the measures referring to the same risk of the project and accomplishing its objectives. The project risk management (PRM) system should be based on the competences of the employees willing to use them to achieve the project’s goal. The system should track down all the processes and their exposure which occur in the project, as well as the circumstances that generate risk and determine their effects. Nowadays, the Big Data (BD) analysis appears an emerging method to create knowledge from the data being generated by different sources in production processes. According to Górecki, the BD seems to be the adequate tool for PRM. BUSINESS RISK MANAGEMENT (BRM) Business Risk management is a subset of risk management used to evaluate the business risks involved if any changes occur in the business operations, systems and process. It identifies, prioritizes and addresses the risk to minimize penalties from unexpected incidents, by keeping them on track. It also enables an integrated response to multiple risks, and facilitates a more informed risk-based decision making capability. 272 CU IDOL SELF LEARNING MATERIAL (SLM)

Businesses today are unpredictable, volatile and seem to become more complex every day. By its very nature, it is filled with risk. Businesses have viewed risk as an evil that should be minimized or mitigated, whenever possible. However, risk assessment provides a mechanism for identifying which risks represent opportunities and which represent potential pitfalls. Risks can have negative impact, positive impact, or both. Risks with a negative impact can prevent value creation or erode existing value. Risks with positive impact may offset negative impacts or represent opportunities. The risk management process involves: 1. Identifying risks – Spotting the evolving risks by studying internal and external factors that impact the business objectives 2. Analyzing risks – It includes the calibration and, if possible, creation of probability distributions of outcomes for each material risk. 3. Responding to risk – After identifying and analyzing the potential risk, appropriate strategy needs to be incorporated. Either by establishing new processes or eliminating, depending on kind and severity of the risk. 4. Monitoring risk and opportunities – Continually measuring the risks and opportunities of the business environment. Also keep a check on performance of management strategies. Types of risks • Hazard risk: A hazard is anything in the workplace that has the potential to harm people. Hazard risk includes factors which are not under the control of business environment, such as fallout of machinery or dangerous chemical, natural calamities. • Financial risk: A large number of businesses take risk with their financial assets, quite regularly. Sometimes choosing a wrong supplier or distributor can backfire. Financial risk also includes risk in pricing, currency exchange and during liquidation of anyasset. Business risk management should say how much risk is too much in financial relationship. • Operational risk: Evaluation ofrisk loss resulting from internal process, system, people or due to any external factor through which a company operates. • Strategic risks: Might arise from making poor or wrong business plans and losing the competition in the market. Failure to respond to changes in the business environment or inadequate capital allocation also represents strategic risk. SUMMARY In a corporate setting, the familiar division of risks into market, credit and operational risks 273 CU IDOL SELF LEARNING MATERIAL (SLM)

breaks down. Of these, credit risk poses the least challenges. To the extent that corporations take credit risk (some take a lot; others take little), new and traditional techniques of credit risk management are well established and transferable from one context to another. Operational risk has little applicability to most corporations. It includes such factors as model risk or settlement errors. Some aspects do affect corporations—such as fraud or natural disasters—but corporations have been addressing these with internal audit, facilities management and legal departments for decades. Corporations may face risks that are akin to the operational risk of financial institutions but are unique to their own business lines. An airline is exposed to risks due to weather, equipment failure and terrorism. A power generator faces the risk that a generating plant may go down for unscheduled maintenance. In corporate risk management, these risks—those that overlap with the operational risks of financial firms and those that are akin to such operational risks but are unique to non-financial firms—are called operations risks. The biggest challenge of corporate risk management is those risks that are akin to market risk but aren’t market risk. An oil company holds oil reserves. Their “value” fluctuates with the market price of oil, but what does this mean? Oil reserves don’t have a market value. As another example, suppose a chain of restaurants is thriving. Its restaurants are “valuable,” but it is impossible to assign them market values. Something that doesn’t have a market value doesn’t pose market risk. This is almost a tautology. Such risks are business risks as opposed to market risks. KEYWORDS • Key Performance Indicator (KPI): A measurement with a defined set of goals and tolerances that gauges the performance of an important business activity • Key Risk Indicator (KRI): A proactive measurement for future and emerging risks that indicates the possibility of an event that adversely affects business activities • Likelihood: The probability of a risk occurring • Mitigation Actions: The necessary steps, or action items, to reduce the likelihood and/or impact of a potential risk • Operation Risk Profile: The risk arising from the execution of an organization’s business processes; The risk of loss resulting from failed or inadequate internal processes, systems, people, or other entities LEARNING ACTIVITY 1. Identify the factors which are important while framing the systematic framework for risk 274 CU IDOL SELF LEARNING MATERIAL (SLM)

management in Banks. 2. What are the different types of risks that banks are exposed to in the present day context? UNIT END QUESTIONS A. Descriptive Question 1. Explain what do you understand by the concept of risk management 2. Explain strategic risk management. 3. Explain project risk management 4. Explain business risk management and assumptions. Long questions 5. Discuss the concept of Business Risk Management 6. Gwendolyn and Jack Francis are typical investors. As they approach retirement, which approach will they likely take? Explain Why 7. The bidders when ranked from the highest price bid to the lowest are: H, C, F, A, B, D, E, and G. Bidders H, C, and F have bid for 140,000 shares. A has bid for 20,000. Theprice that nears the market is the price that was bid by A, or $100. H, C, Fand get their orders filled at this price. Half of A’s order is filled at this price B. Multiple Choice Questions (MCQs) 1. A tornado swept through a city making it difficult for a small business to earn money for some time. What kind of insurance would help to minimize the loss of income? a. Errors and Omissions Insurance b. General Liability Insurance c. Directors and Officers Insurance d. Business Interruption Insurance 2. The proposition that a prediction based upon a sample of 10,000 occurrences is more 275 CU IDOL SELF LEARNING MATERIAL (SLM)

accurate than a prediction based upon 100 occurrences is an illustration of the . a. first law of prediction b. first law of probability c. law of large numbers d. law of risk management 3. Assessing risks in terms of probability and magnitude of impact is called: a. risk management b. risk assessment c. risk assumption d. risk avoidance e. risk identification 4. What is the process for determining the types of risks to which the company is exposed: a. risk assessment b. risk identification c. risk mitigation d. risk assumption 5. Project Risk Management includes all of the following processes except: a. Risk Monitoring and Control b. Risk Identification c. Risk Avoidance d. Risk Response Planning e. Risk Management Planning 6. Risk, as distinct from uncertainty considers: a. a qualitative approach b. a Maximaxapproaches 276 CU IDOL SELF LEARNING MATERIAL (SLM)

c. a quantitative approach d. a maximin approach 7. Which of the following is not a source of financial risk? a. credit terms b. exchange rates c. interest rates d. marketing mix 8. The exchange rate equivalency model excludes which of the following? a. Interest Rate Parity Theory b. International Fisher Effect c. Expectations Theory d. International Fletcher Effect 9. Interest rate risk is not faced by: a. lenders b. borrowers c. ordinary shareholders d. debenture holders 10. Exchange rate risk does not include: a. transaction risk b. transposition risk c. translation risk d. economic risk Answers 1. d 2.d 3. b 4. b 5. A 6.c 7.c 8.d 9.d 10.c REFERENCES • Dorfman, Mark S. (2007). Introduction to Risk Management and Insurance (9 ed.). 277 CU IDOL SELF LEARNING MATERIAL (SLM)

Englewood Cliffs, N.J: Prentice Hall. ISBN 0-13-224227-3. • McGivern, Gerry; Fischer, Michael D. (1 February 2012). \"Reactivity and reactions to regulatory transparency in medicine, psychotherapy and counseling\" (PDF). Social Science & Medicine. 74 (3): 289–296. doi:10.1016/j.socscimed.2011.09.035. PMID 22104085. • IADC HSE Case Guidelines for Mobile Offshore Drilling Units 3.2, section 4.7 • Roehrig, P (2006). \"Bet On Governance To Manage Outsourcing Risk\". Business Trends Quarterly. • Damodaran, A. (2007). Corporate Finance –Theory & Practice, Hoboken, New Jersey: John Wiley and Sons, Inc. • M Y Khan, P K Jain. (2018). Financial Management, New Delhi: Tata Mc Graw Hill. • Pandey, I.M. (2016). Financial Management. New Delhi: Vikas Publication House Pvt. Ltd. • Richard A Brealey, Stewart C myers, Franklin Allen, Pitabas Mohanty. (2018). Principles of Corporate Finance. New Delhi: Tata Mc Graw Hill. 278 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 10 FINANCIAL RISK MANAGEMENT Structure Learning objectives Introduction Financial Risk Management Market Risk Credit Risk Liquidity Risk Operational Risk How Do You Implement Financial Risk Control? Who Manages Financial Risk? Economic Value Book Value Cash flow risk Effective Cash Flow Risk Management Matters Improving Your Cash Flow Risk Management Summary Keywords Learning activity Unit end questions References LEARNING OBJECTIVES After studying this lesson, you will be able: • Explain financial risk management • Study about market risks, credit risks, liquidity risk and operational risks • State about Cash flow risks INTRODUCTION Financial risk management is the practice of protecting economic value in a firm by using 279 CU IDOL SELF LEARNING MATERIAL (SLM)

financial instruments to manage exposure to risk: operational risk, credit risk and market risk, foreign exchange risk, shape risk, volatility risk, liquidity risk, inflation risk, business risk, legal risk, reputational risk, sector risk etc. Similar to general risk management, financial risk management requires identifying its sources, measuring it, and plans to address them. FINANCIAL RISK MANAGEMENT Financial risk management can be qualitative and quantitative. As a specialization of risk management, financial risk management focuses on when and how to hedge using financial instruments to manage costly exposures to risk. In the banking sector worldwide, the Basel Accords are generally adopted by internationally active banks for tracking, reporting and exposing operational, credit and market risks. Finance theory (i.e., financial economics) prescribes that a firm should take on a project if it increases shareholder value. Finance theory also shows that firm managers cannot create value for shareholders, also called its investors, by taking on projects that shareholders could do for themselves at the same cost. When applied to financial risk management, this implies that firm managers should not hedge risks that investors can hedge for themselves at the same cost. This notion was captured by the so-called \"hedging irrelevance proposition\": In a perfect market, the firm cannot create value by hedging a risk when the price of bearing that risk within the firm is the same as the price of bearing it outside of the firm. In practice, financial markets are not likely to be perfect markets. This suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management, wherein they have to determine which risks are cheaper for the firm to manage than the shareholders. Market risks that result in unique risks for the firm are commonly the best candidates for financial risk management. The concepts of financial risk management change dramatically in the international realm. Multinational Corporations are faced with many different obstacles in overcoming these challenges. There has been some research on the risks firms must consider when operating in many countries, such as the three kinds of foreign exchange exposure for various future time horizons: transactions exposure, accounting exposure, and economic exposure Anything that relates to money flowing in and out of the business is a financial risk. Since the list of potential risks is so long, most analysts place them into one of four categories as follows: MARKET RISK As the name implies, a market risk is any risk that comes out of the marketplace in which 280 CU IDOL SELF LEARNING MATERIAL (SLM)

your business operates. For example, if you are a bricks-and-mortar clothing store, the increasing tendency of customers to shop online would be a market risk. Businesses that adapt to serve the online crowd have a better chance of surviving than businesses who stick to the offline business model. More generally and whatever sector you're in, every business runs the risk of being outpaced by competitors. If you don't keep up with consumer trends and pricing demands, then you're likely to lose market share. CREDIT RISK Credit risk is the possibility that you'll lose money because someone fails to perform according to the terms of a contract. For example, if you deliver goods to customers on 30- day payment terms and the customer does not pay the invoice on time (or at all), then you have suffered a credit risk. Businesses must retain sufficient cash reserves to cover their accounts payable or they are going to experience serious cash flow problems. LIQUIDITY RISK Also known as funding risk, this category covers all the risks you encounter when trying to sell assets or raise funds. If something is standing in your way of raising cash fast, then it's classified as a liquidity risk. A seasonal business, for example, might experience significant cash flow shortages in the off-season. Do you have enough cash put aside to meet the potential liquidity risk? How quickly can you dispose of old inventory or assets to get the cash you need to keep the lights on? Liquidity risk also includes currency risk and interest rate risk. What would happen to your cash flows if the exchange rate or interest rates were to suddenly change? OPERATIONAL RISK Operational risk is a catch-all term that covers all the other risks a business might encounter in its daily operations. Staff turnover, theft, fraud, lawsuits, unrealistic financial projections, poor budgeting and inaccurate marketing plans can all pose a risk to your bottom line if they are not anticipated and handled correctly. Financial risk management is the process of understanding and managing the financial risks that your business might be facing either now or in the future. It's not about eliminating risks, since few businesses can wrap themselves in cotton wool. Rather, it's about drawing a line in the sand. The idea is to understand what risks you're willing to take, what risks you'd rather avoid, and how you're going to develop a strategy based on your risk appetite. The key to any financial risk management strategy is the plan of action. These are the practices, procedures and policies your business will use to ensure it doesn't take on more risk 281 CU IDOL SELF LEARNING MATERIAL (SLM)

than it is prepared for. In other words, the plan will make it clear to staff what they can and cannot do, what decisions need escalating, and who has overall responsibility for any risk that might arise. BUSINESS RISK Business risk is the exposure a company or organization has to factor(s) that will lower its profits or lead it to fail. Anything that threatens a company's ability to achieve its financial goals is considered a business risk. There are many factors that can converge to create business risk. Sometimes it is a company's top leadership or management that creates situations where a business may be exposed to a greater degree of risk. However, sometimes the cause of risk is external to a company. Because of this, it is impossible for a company to completely shelter itself from risk. However, there are ways to mitigate the overall risks associated with operating a business; most companies accomplish this through adopting a risk management strategy. Understanding Business Risk When a company experiences a high degree of business risk, it may impair its ability to provide investors and stakeholders with adequate returns. For example, the CEO of a company may make certain decisions that affect its profits, or the CEO may not accurately anticipate certain events in the future, causing the business to incur losses or fail. Business risk is influenced by a number of different factors including: Consumer preferences, demand, and sales volumes Per-unit price and input costs Competition The overall economic climate Government regulations A company with a higher amount of business risk may decide to adopt a capital structure with a lower debt ratio to ensure that it can meet its financial obligations at all times. With a low debt ratio, when revenues drop the company may not be able to service its debt (and this may lead to bankruptcy). On the other hand, when revenues increase, a company with a low debt ratio experiences larger profits and is able to keep up with its obligations. HOW DO YOU IMPLEMENT FINANCIAL RISK CONTROL? Organizations manage their financial risk in different ways. This process depends on what the business does, what market it operates in and the level of risk it is prepared to accept. In this 282 CU IDOL SELF LEARNING MATERIAL (SLM)

sense, it's up to the business owner and directors of the company to identify and assess the risk and decide how the company is going to manage them. Some of the stages in the financial risk management process are: Identifying the risk exposures Risk management starts by identifying the financial risks, and their sources or causes. Agood place to start is with the company's balance sheet. This provides a snapshot of the debt, liquidity, foreign exchange exposure, interest rate risk and commodity price vulnerability the company is facing. You should also examine the income statement and the cash flow statement to see how income and cash flows fluctuate over time, and the impact this has on the organization's risk profile. Questions to ask here include: What are the main sources of revenue of the business? Which customers does the company extend credit to? What are the credit terms for those customers? What type of debt does the company have? Short-term or long-term? What would happen if interests’ rates were to rise? Quantifying the exposure The second step is to quantify or put a numerical value on the risks you've identified. Of course, risk is uncertain, and putting a number on risk exposure will never be exact. Analysts tend to use statistical models such as the standard deviation and regression method to measure a company's exposure to various risk factors. These tools measure the amount by which your data points differ from the average or mean. For small businesses, computer software like Excel can help you to run some straightforward analysis in an efficient and accurate way. The general rule is the greater the standard deviation, the greater the risk associated with the data point or cash flow you're quantifying. Making a \"hedging\" decision After you've analyzed the sources of risk, you must decide how you will act on this information. Can you live with the risk exposure? Do you need to mitigate it or hedge against it in some way? This decision is based on multiple factors such as the goals of the company, 283 CU IDOL SELF LEARNING MATERIAL (SLM)

its business environment, its appetite for risk and whether the cost of mitigation justifies the reduction in risk. Generally, you might consider the following action steps: Reducing cash-flow volatility. Fixing interest rates on loans so you have more certainty in your financing costs. Managing operating costs. Managing your payment terms. Putting rigorous billing and credit control procedures in place. Saying farewell to customers who regularly abuse your credit terms. Understanding your commodity price exposure, that is, your susceptibility to variations in the price of raw materials. If you work in the haulage industry, for example, a rise in oil prices can increase costs and reduce profits. Making sure the right people are given the right jobs with the right degree of supervision, to reduce the risk of fraud. Performing due diligence on projects, for example, considering the uncertainties associated with a partnership or joint venture. WHO MANAGES FINANCIAL RISK? In a small business, the business owner and senior managers are responsible for risk management. It's only when the business grows to include multiple departments and activities that you may wish to bring in a dedicated Financial Risk Manager to manage risk — and make recommendations for action — on behalf of the company. The Global Association of Risk Professionals is recognized globally as the premier accreditation for Financial Risk Management professionals. To receive the FRM certification, candidates must have two years' work experience and pass a rigorous exam risk on the subjects of market risk, credit risk, operational risk and investment management. Details are available on the GARP website. ECONOMIC VALUE Techniques of the first form focus on a concept called economic value. If a market value exists for an asset, then that market value is the asset’s economic value. If a market value doesn’t exist, then economic value is the “intrinsic value” of the asset—what the market value of the asset would be, if it had a market value. Economic values can be assigned in two 284 CU IDOL SELF LEARNING MATERIAL (SLM)

ways. One is to start with accounting metrics of value and make suitable adjustments, so they are more reflective of some intrinsic value. This is the approach employed with economic value added (EVA) analyses. The other approach is to construct some model to predict what value the asset might command, if a liquid market existed for it. In this respect, an unflattering name for economic value is mark-to-model value. Once some means has been established for assigning economic values, these are treated like market values. Standard techniques of financial risk management—such as value-at-risk (VaR) or economic capital allocation—are then applied. This economic approach to managing business risk is applicable if most of a firm’s balance sheet can be marked to market. Economic values then only need to be assigned to a few items in order for techniques of financial risk management to be applied firm wide. An example would be a commodity wholesaler. Most of its balance sheet comprises physical and forward positions in commodities, which can be mostly marked to market. More controversial has been the use of economic valuations in power and natural gas markets. The actual energies trade and, for the most part, can be marked to market. However, producers also hold significant investments in plants and equipment—and these cannot be marked to market. Suppose some energy trades spot and forward out three years. An asset that produces the energy has an expected life of 50 years, which means that an economic value for the asset must reflect a hypothetical 50-year forward curve. The forward curve doesn’t exist, so a model must construct one. Consequently, assigned economic values are highly dependent on assumptions. Often, they are arbitrary. In this context, it isn’t enough to assign economic values. Value-at-risk analyses require standard deviations and correlations as well. Assigning these to 50-year forward prices that are themselves hypothetical is essentially meaningless—yet, those standard deviations and correlations determine the reported value-at-risk. Such practices got out of hand in the US energy markets during the late 1990s and early 2000s. The most publicized case was Enron Corp., which went beyond using economic values for internal reporting and incorporated them into its financial reporting to investors. The 2001 bankruptcy of Enron and subsequent revelations of fraud tainted mark-to-model techniques. BOOK VALUE The second approach to addressing business risk starts by defining risks that are meaningful in the context of book value accounting. Most typical of these are: • Earnings risk, which is risk due to uncertainty in future reported earnings, and • Cash flow risk, which is risk due to uncertainty in future reported cash flows. 285 CU IDOL SELF LEARNING MATERIAL (SLM)

Of the two, earnings risk is more akin to market risk. Yet, it avoids the sometimes arbitrary assumptions of economic valuations. A firm’s accounting earnings are a well-defined notion. A problem with looking at earnings risk is that earnings are, well, non-economic. Earnings may be suggestive of economic value, but they can be misleading and are often easy to manipulate. A firm can report high earnings while its long term franchise is eroded by lack of investment or the emergence of competing technologies. Financial transactions can boost short-term earnings at the expense of long-term earnings. Cash flow risk is less akin to market risk. It relates more to liquidity than the value of a firm, but this is only partly true. As anyone who has ever worked with distressed firms can attest, “cash is king.” When a firm gets into difficulty, earnings and market values don’t pay the bills. Cash flow is the life blood of a firm. However, as with earnings risk, cash flow risk offers only an imperfect picture of a firm’s business risk. Cash flows can also be manipulated, and steady cash flows may hide corporate decline. Techniques for managing earnings risk and cash flow risk draw heavily on techniques of asset-liability management—especially scenario analysis and simulation analysis. They also adapt techniques of financial risk management. In this context, value-at-risk (VaR) becomes earnings-at-risk (EaR) or cash-flow-at-risk (CFaR). For example, EaR might be reported as the 10% quantile of this quarter’s earnings. The actual calculations of EaR or CFaR differ from those for VaR. These are long-term risk metrics, with horizons of three months or a year. VaRis routinely calculated over a one-day horizon. Also, EaR and CFaR are driven by rules of accounting while VaR is driven by financial engineering principles. Typically, EaR or CFaRare calculated by first performing a simulation analysis. That generates a probability distribution for the period’s earnings or cash flow, which is then used to value the desired metric of EaR or CFaR. One decision that needs to be made with EaR or CFaR is whether to use a constant or contracting horizon. If management wants an EaR analysis for quarterly earnings, should the analysis actually assess risk to the current quarter’s earnings? If that is the case, the horizon will start at three months on the first day of the quarter and gradually shrink to zero by the end of the quarter. The alternative is to use a constant three-month horizon. After the first day of the quarter, results will no longer apply to that quarter’s actual earnings, but to some hypothetical earnings over a shifting three-month horizon. Both approaches are used. The advantage of a contracting horizon is that it addresses an actual concern of management— will we hit our earnings target this quarter? A disadvantage is that the risk metric keeps changing—if reported EaR declines over a week, does this mean that actual risk has declined, or does it simply reflect a shortened horizon? 286 CU IDOL SELF LEARNING MATERIAL (SLM)

CASH FLOW RISK A river of money flows in and out of your business every day, and if you’re not managing it effectively, you might find your coffers running dry when it’s time to pay bills, cover surprise expenses, or direct capital into innovation and growth. Cash flow risk is the term used to describe the potential danger of falling short created by your cash flow management practices— the lower your cash flow risk, the better equipped your company will be to use its working capital effectively. Taking control of your cash flow risk can seem daunting. But by implementing the right best practices, you can optimize your cash flow risk management and rest easy knowing you have the funds you need, when you need them most. While it may be confused or conflated with profits by some, cash flow is actually a process, not just a figure on the balance sheet. Cash flow can be positive (more cash is flowing in than out) or negative (more cash is flowing out than in). Negative cash flow presents a much higher financial risk for businesses of all sizes and types, especially since it’s possible for a company to have a negative cash flow while still generating a profit. That’s why cash flow has its own financial documentation (the cash flow statement) to record all cash flowing in and out of an organization through its financing activities, operations, and investments. The profit and loss statement (also called the income statement), on the other hand, records expenses, total sales, and profits. The two are indeed connected, but profits are not the same as cash; rather, a net loss on the income statement increases cash flow risk, since capital will be diverted to cover the gap between sales and operating costs. Investors and lenders regard long-term positive cash flow as an indicator of value generation, creditworthiness, and stability. Consequently, managing cost flow risk is crucial to both the immediate financial health and long-term growth of your company. Effective Cash Flow Risk Management Matters A lack of readily available capital can make or break a business—particularly during tough times, such as a recession or a pandemic like the COVID-19 crisis. Cash is used to cover not just short-term debts like vendor invoices and operating costs, but interest payments on long- term financing. Without careful, consistent, and complete cash flow risk management, a company could find itself teetering on the brink of disaster due to a lack of readily available funds. To understand cash flow risk, it’s important to know a few key terms: • Cash Flow at Risk (CFaR) is a measure of how changes in market variables can cause future cash flows to fall short of expectations, as well as the extent of those changes byrisk factor. 287 CU IDOL SELF LEARNING MATERIAL (SLM)

• Value at Risk (VaR): Similar to CFAR. A metric used to measure an investment’s potential loss over a specific time period, generally expressed as the probability of loss exceeding a specific threshold (e.g., $3 million over a given year). • Liquidity Risk: A measure of how well an organization can cover its short-term financial obligations. Liquidity risk increases when a company lacks the working capital to cover these costs, or has sufficient assets, but cannot readily access them in a timely fashion or without significant financial loss. A comprehensive cash flow risk management strategy accounts for the many different scenarios in business-critical areas that can affect, and are affected by, cash flow, including: • Operational Strategy: The standards and practices set for accounts receivable, procurement, and accounts payable will have a pronounced impact on how cash enters and exits a business, and a direct impact on a company’s liquidity risk. • Market Conditions: The availability of corporate finance options (and the relative ease of corporate financial management) is directly tied to market risk. Small businesses, already hobbled by fewer capital market investment and lending options than their larger brethren, may find themselves struggling to find investments they can readily liquidate to improve cash flow, or long-term investments that provide equity for debt management. This is especially true during a crisis or market downturn/recession. Market conditions have a strong impact on both CFAR and VAR for both your business and your evaluation of other organizations in which you may choose to invest. • Industry-Specific Risks: A sharp downturn in any industry, whether due to economic disruption, abrupt changes to commodity prices, a loss of customers, etc., can raiseexpenses and reduce sales, slashing operational cash flows. • Investment Strategy: While major investments are generally long-term, rather than short- term, expenses, they can absolutely affect cash flow. Interest payments (and their associated interest rates) can consume a sizable chunk of available cash during a given period, depending on your company’s investment strategy. In addition, pouring large amounts of capital into expensive equipment or real estate can raise cash flow at risk by reducing liquidity for the immediate and near future. • Balancing Short- and Long-Term Debt: Striking the right balance between debt and equity is crucial to keeping cash flow risk to a minimum. Too many short-term debts can create a crisis if they’re called in when cash is low, while long term investments may not be as readily available for small businesses. Improving Your Cash Flow Risk Management In tackling a complex process like cash flow management to improve performance, reduce overall risk as well as cash flow at risk and value at risk, and effectively track (and manage) 288 CU IDOL SELF LEARNING MATERIAL (SLM)

debt capacity, you need a clear plan and the right tools. Consider making these best practices part of your cash flow risk management strategy: 1. Invest in Automation and AI Reducing all your financial risks, including cash flow risk, begins with total transparency into, and control over, your company’s financial activity. A comprehensive solution like Purchase Control gives you access to tools you can use to: • Perform smart and strategic risk assessment. • Monitor and optimize your entire procure-to-pay (P2P) process • Leverage on-demand visibility of all your company’s cash flows (both in and out) • Integrate your P2P workflows with other accounting software to ensure you have accurate and complete information you need to manage cash flow and reduce risk. In addition, by centralizing your data management, strengthening your reporting and forecasting capabilities, and incorporating process optimization (including key performance enhancers such as automatic three-way matching of vendor invoices), you’ll be able to implement all the other best practices for cash flow risk management more effectively. 2. Optimize Your Cash Inflow In good times and bad (but especially in bad), making the most of every incoming dollar is crucial to business continuity and growth. You can gain better visibility into, and control over, incoming cash flows by: • Offering your customers a variety ofpayment options. More options increase the likelihood of faster payment. • Promptly issuing and following up on invoices. • Providing clear incentives for early payment (including the occasional earlypayment discount where prudent) and firm consequences (including fees) for late payments. • Increase your customer base by: • Developing new goods or services. • Getting creative with your marketing to reach new markets. • Developing and implementing a referral program to grow business and rewardloyal customers. • Performing additional cost and market research to determine whether you can, and should, be charging higher prices for goods and services. • Selling your unpaid invoices in order to generate cash immediately (i.e., invoice factoring). The purchaser takes a small fee off the top and then collects the payment from the 289 CU IDOL SELF LEARNING MATERIAL (SLM)

original customer. • Strategically leveraging small business loans to fund expansions, purchase new equipment, cover unexpected costs (or mitigate seasonal shortages), and invest in research and development. 3. Optimize Your Outgoing Cash Flows Chances are, your management team wants the biggest possible return on investment (ROI) for every dollar you spend, along with healthy levels of liquidity, VAR and CFAR. You can make it happen by: • Reviewing and eliminating any unnecessary expenses. • Making strategic upgrades to equipment and technology. The immediate costs will be readily offset by long-term value in the form of greater production capacity and efficiency, as well as lower maintenance and labour costs that free up more cash. • Optimizing your workflows to reduce cycle times for both purchase orders and invoices. • Using a comprehensive P2P solution can make this much easier, and provide a foundation for a larger digital transformation and business process optimization • Automation and data management create a closed buying environment that lowers costs and increases value by eliminating rogue spend and invoice fraud. • Capturing more discounts from vendors through early payments. • Taking strategic advantage of extended payment terms when you need more cash. • Negotiating the best possible payment terms with vendors through contractnegotiation and supplier relationship management (strategic partnerships, e.g.). • Transferring some short-term debt to long-term debt through financing or the use of corporate credit cards. Keep Your Cash Flowing and Your Business Thriving Is your company’s cash flow a healthy torrent you can tap on demand, or an unpredictable deluge that suddenly becomes a trickle when you need it most? Invest in the tools and techniques you need for effective cash risk management, and you’ll have a firm grasp on your company’s working capital, visibility into and control over cash payments, and stronger resistance to cash flow volatility that can hurt not only your operational agility, but your credit rating and perceived value generation for investors and lenders. SUMMARY Financial risk management is the process of understanding and managing the financial risks that your business might be facing either now or in the future. It's not about eliminating risks, 290 CU IDOL SELF LEARNING MATERIAL (SLM)

since few businesses can wrap themselves in cotton wool. Rather, it's about drawing a line in the sand. The idea is to understand what risks you're willing to take, what risks you'd rather avoid, and how you're going to develop a strategy based on your risk appetite. The key to any financial risk management strategy is the plan of action. These are the practices, procedures and policies your business will use to ensure it doesn't take on more risk than it is prepared for. In other words, the plan will make it clear to staff what they can and cannot do, what decisions need escalating, and who has overall responsibility for any risk that might arise. KEYWORDS • Expected value: The weighted average of a probability distribution • Option: A contract that gives the holder the right, but not the obligation, to buy or sell a specified quantity of a security at a specified price within a specified period of time. • Risk: The degree of uncertainty of return on an asset. Exposure to potential loss or damage. • Standard deviation: A measure of dispersion of a set of data from its mean. • Variance: A measure of the volatility or risk on an investment. Dispersion of a set of data points around their mean value. In mathematical terms, the square root of the variance is the standard deviation. LEARNING ACTIVITY 1. Discuss the role of Book Value in accounting. 2. As a CFO what kind of risk management policies you will implement in the organization UNIT END QUESTIONS 291 A. Descriptive Question 1. Explain, what do you understand by FRM? 2. Explain the market risk & Credit risk. 3. Explain economic value. 4. Explain cash flow and cash flow risk? CU IDOL SELF LEARNING MATERIAL (SLM)

5. Discuss the difference of economic value and market value? Long Questions 1. A firm is planning a $25 million expansion project. The project will be financed with $10 million in debt and $15 million in equity stock (equal to the company's current capital structure). The before-tax required return on debt is 10% and 15% for equity. If the company is in the 35% tax bracket, what cost of capital should the firm use to determine the project's net present value (NPV)? B. Multiple Choice Questions (MCQs) 1. Traditionally, corporate risk management considered all of the following risks EXCEPT a. Liability risks. b. Financial risks. c. Property risks. d. Personnel risks. 2. Which of the following is most likely to occur in a hard• insurance market? a. high insurance premiums and loose underwriting standards b. low insurance premiums and loose underwriting standards c. low insurance premiums and tight underwriting standards d. high insurance premiums and tight underwriting standards 3. A computerized database that permits the risk manager to store and analyze risk management data is called a. a. Risk map. b. Risk management intranet. c. Risk management software program. d. Risk management information system. 4. A comprehensive risk management program that addresses anorganizations pure risks, speculative risks, strategic risks, and operational risks is called a(n) a. Financial risk management program. 292 CU IDOL SELF LEARNING MATERIAL (SLM)

b. Enterprise risk management program. c. Integrated risk management program. d. Double-trigger option program. 5. The risk management departments of some companies have developed interactive networks incorporating search capabilities. These networks are designed for limited, internal use. Such networks are called a. Enterprise risk management plans. b. Risk management intranets. c. Risk maps. d. Risk management information systems. 6. Listed companies can be valued at a. Book Value b. Market value c. Salvage value d. Liquidation value 7. Unlisted company can be valued at a. Net asset Method b. Market value method c. Both a & b d. None of these 8. Book value is . a. the same as market value b. a more accurate valuation technique than the dividend models c. the accounting value of the firm as reflected in the financial statements d. the same as liquidation value 293 CU IDOL SELF LEARNING MATERIAL (SLM)

9. What is the value of the firm usually based on? a. The value of debt and equity. b. The value of equity. c. The value of debt. d. The value of assets plus liabilities. 10. This type of risk is avoidable through proper diversification. a. portfolio risk b. systematic risk c. unsystematic risk d. total risk Answers 1.b 2. d 3. d 4. b 5. b 6.b 7. A 8.c 9.b 10. c REFERENCES • Peter F. Christofferson (22 November 2011). Elements of Financial Risk Management. Academic Press. ISBN 978-0-12-374448-7. • Allan M. Malz (13 September 2011). Financial Risk Management: Models, History, and Institutions. John Wiley & Sons. ISBN 978-1-118-02291-7. • Van Deventer, Donald R., and Kenji Imai. Credit risk models and the Basel Accords. Singapore: John Wiley & Sons (Asia), 2003. • Drumond, Ines. \"Bank capital requirements, business cycle fluctuations and the Basel Accords: a synthesis.\" Journal of Economic Surveys 23.5 (2009): 798-830. • Damodaran, A. (2007). Corporate Finance –Theory & Practice, Hoboken, New Jersey: John Wiley and Sons, Inc. • M Y Khan, P K Jain. (2018). Financial Management, New Delhi: Tata Mc Graw Hill. • Pandey, I.M. (2016). Financial Management. New Delhi: Vikas Publication House Pvt. Ltd. • Richard A Brealey, Stewart C myers, Franklin Allen, Pitabas Mohanty. (2018). Principles of Corporate Finance. New Delhi: Tata Mc Graw Hill. 294 CU IDOL SELF LEARNING MATERIAL (SLM)

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